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Corporate Governance and the Agency Problem: continued

The Agency Problem and Conflict of Interests

Layer One: The Plan Administrator

An employer sets up and administers a 401(k) plan, determining the investments that a participant might choose, the vesting provisions, the conditions for matching funds, and other details.

The plan document carefully places the investment risk entirely on the employee and makes no claim that the 401(k) plan will provide adequate support in the investor's old age.

Prior to the 1970s, many U.S. corporations offered retirement plans with defined benefits. For example, a worker might be able to look forward to a retirement annuity equal to, say, seventy percent of his or her average income in the last decade of employment.

These plans were honest in intention and provided real advantages. However, sometimes pension promises were not funded. When companies went bankrupt, workers faced old age with no cash flow other than meager social security checks.

To remedy this, the government established strict requirements for defined-benefit pension plans, while guaranteeing such programs. However, the rules were bureaucratic and costly.

Employers reacted by avoiding, reducing, or eliminating defined-benefit plans; company pensions became less common. Congress responded with fiscal incentives for a retirement alternative – 401(k) plans – which were less burdensome to employers and better than no plan at all. The 401(k) plans were funded out of workers' salaries.

Unlike defined-benefit plans, when stock prices fell or interest rates rose, the employer would not be called upon to cover losses. As a recruiting benefit and way to tie employees to the firm, companies could offer to match an investor's savings, within limits, stipulating that these additional amounts would become vested only in time – often five years.

When an employee resigned or was fired, the effective cost of matching funds was reduced.

A particularly deplorable aspect of the 401(k) idea was that many companies encouraged employees to invest their life savings in shares of their employer's company, while sponsoring stock option plans for executives and massive stock buyback programs that depleted corporate finances.

In this way, a portion of employees' wages, intended for long-term investment, was recycled to buy management stock, helping to provide bosses with multi-million dollar remuneration while lesser employees were sacked at the slightest flutter in sales or earnings.

Executives, focusing on quarterly results and their brief chance at the top, could dissipate company capital to boost stock prices, while ignoring the needs of less sophisticated workers who ingenuously hoped to hold company stock for thirty-five years or more.

The U.S. government closely regulates 401(k) and other retirement related savings plans. These rules give fiduciary responsibility to plan administrators who are supposed to design programs that are in the best interests of workers.

However, what this actually means is not defined, and any claim for strict interpretation of fiduciary responsibility is fatally weakened by the government having allowed plan administrators to suggest stock of the administrator's company as a prudent retirement vehicle.

From ERISA to 401(k)s

The purpose of the ERISA program of the 1970s was to ensure that retired workers not be impoverished by unfunded pensions should their employer go bankrupt.

This was achieved by establishing that defined-benefit retirement plans should be applied in diversified portfolios of securities, with values verified by actuaries and with government guaranteed solvency.

In contrast, 401(k) provisions permitted retirement schemes that were just as insecure as non-funded, company pension plans of the 1950s, except that these could be entirely financed by the employee.

By allowing administrators to suggest investment in an employer's stock, the worker was presented with as great a risk of being wiped out should the company fail as under pre-ERISA pensions, with additional drawbacks of not having defined-benefits or government backup, while paying at least half of the cost through payroll deductions.

Layer Two: 401(k) Plan Trustees

The funds that a worker authorizes to be paid into a 401(k) plan are held in the name of a trustee, usually a large, money-center bank or mutual fund group.

The trustee's job is to serve as a custodian, which includes responsibility for voting the mutual fund or company shares in which the employee is a beneficial owner.

The common questions that are brought to a vote, involve the selection of auditors, election of directors, and changes in a fund's charter. When voting fund shares, trustees almost always go along with whatever is proposed by the management company, which is often owned by the same group as that of the trustees.

Sometimes the trustees are responsible for providing plan-holders with statements – often little more than lists of debits and credits to the employee's share account and a recent market valuation.

There is no reporting as to the adequacy of the investor's savings for a particular retirement goal, nor is any information given that would help a worker understand the intrinsic value of securities owned indirectly through various funds.

Layer Three: Fund Directors

Open-end mutual funds in the U.S. are usually organized as corporations and have largely ceremonial, but legally potent, boards of directors that are nominated by the management company.

Many of these directors are employees and executives of the fund manager. Remuneration of independent directors of mutual funds is not exorbitant, and these directors attract little attention and usually do the fund managers' bidding.

Fund directors approve reports on portfolio performance and pass on recommendation to the trustees regarding appointment of auditors, investment managers, and changes in the fund's charter.

Sometimes the annual report will be sent through the trustee and plan administrator to the beneficial owners, but other material such as proxies for election of directors, often does not get beyond the trustees.

Layer Four: Fund Managers

Fund managers decide whether the investor will hold Boeing stock. As long as a particular stock meets the requirements for inclusion in a fund's portfolio, the manager can buy or sell the stock without consulting fund directors, plan trustees, or plan administrators.

Whether the decision is made by a single manager or by a committee, the objective is almost always to boost short-term portfolio performance.

The primary question is whether the stock price is likely to go up or down in the next year. Many managers do not do their own research but depend upon recommendations of stockbrokers.

Fund managers do not ordinarily attend meetings of shareholders of companies held in portfolio. When the fund belongs to a large group, there may be officials responsible to oversee matters of 'corporate governance' and who vote portfolio shares according to a written policy, such as those posted on the Internet by CalPERS and TIAA-CREF.

The nature of the fund business and the recommendations of stockbrokers, lead most managers to take a short-term view that may be contrary to the interests of beneficial owners of 401(k) plans.

Because their focus is on short-term market fluctuations, fund managers will condone excessive remuneration for company executives and debilitating buyback programs, as long as the price of the stock rises over the next period.

This attitude will not be criticized by the board, the plan trustees, or the plan administrator. The beneficial owner, who only sees the quarterly value of his shares and the total return performance figure, has no interest in or even the ability to understand the implications of financial policy of a company that he doesn't know that he owns and that makes up, at best, only a small sliver of his financial assets.

Layer Five: Company Directors

Under American corporate law, shareholders delegate ample powers to company directors. The directors choose executives, authorize dividends and stock buybacks, set management remuneration, approve mergers and acquisitions, and determine business policy.

Under corporate governance guide lines that have evolved since the 1980s, the boards of widely-held, public companies are supposed to be dominated by directors who are independent of the company and its management. In practical terms, this means that directors that are not executives should make up the majority of the board.

There were eleven directors on the Boeing board in 2002. The make-up was typical of a large public company and followed recommended guidelines on corporate governance.

Two directors held executive positions with Boeing. These were Mr. Condit, CEO and Chairman of the Board, and Mr. Stonecipher, Vice Chairman. Under Robert's Rules of Order, management dominated the board.

Mr. Stonecipher along with Mr. McDonnell, another director and large shareholder, had been executives and board members of McDonnell Douglass Corporation (aerospace) prior to its merger with Boeing.

According to documents filed with the SEC, Mr. Stonecipher's remuneration had already been decided by his employment contract, which would mean that it was part of the deal in the McDonnell Douglas merger.

With Mr. Condit as Chairman, it would be logical that he have higher remuneration than Mr. Stonecipher, Vice-Chairman.

Large mergers can be advantageous to directors on both boards. It is not easy for such arrangements to be negotiated at arm's length, without conflicts of interest.

Six directors had histories as board members or professional executives of other large public companies. Three directors were from outside the business community, having made their names in education, government, and the military.

One director, Mr. Biggs of TIAA/CREF, represented the financial market and institutional investors. Most, if not all, of the directors were not bootstrap capitalist entrepreneurs or founders of large corporations.

Mr. Biggs (TIAA/CREF), Mr. Duberstein (former Whitehouse Chief of Staff), and Ms. Ridgway (former American Ambassador to Finland and State Department career official) made up the Compensation Committee that set management remuneration.

There were two over-riding principles that determined how much executives would earn.

The idea of 'performance-based' compensation was also consistent with TIAA/CREF guidelines and other codes of corporate governance.

Although the question as to what comprises 'executive performance' might ordinarily be difficult for a fair-minded, impartial person to ascertain, the dilemma is easily resolved by applying the principle of 'competitive' remuneration.

The logical combination of these two doctrines guarantees an epidemic of escalating executive pay linked to stock prices.

When Company Able judges executive performance by the rise and fall of stock prices, Company Baker, its competitor, is justified in using the same criteria.

Once the virus of 'competitive performance-based executive remuneration' lands in the warm, friendly agar-agar of board rooms of public companies, a plague of option-buybacks explodes to ravage the supply of equities in capital markets.

Directors' Justification

Boeing had a board dominated by people who had made their mark as professional executives or in the government, it would have been out of character for anyone to oppose an option scheme backed by a stock repurchase plan, especially when the proposal mimicked those of other public companies and was endorsed by experts on executive pay, judged appropriate by a reputable law firm and an independent auditor, and, in the case of Boeing, approved by Mr. Biggs, Chairman of the Compensation Committee and representative of TIAA/CREF, a leader in the corporate governance movement, and, in the minds of reasonable people, the voice of institutional investors that held voting rights for the majority of the company shares.

These directors certainly understood that they had fiduciary responsibility to their shareholders and took their job seriously.

However, which shareholders are to be represented is not clear. Should the board act in the interests of the managers of the funds that controlled the company, or should they look beyond the several layers of fiduciaries to the ultimate beneficial owners – the individuals with 401(k) plans Keogh plans and retirement funds?

If the beneficial owners themselves are primarily interested in short-term capital gains, instead of the final long-term value of their retirement plan, should the directors of Boeing, representing but a tiny piece of the beneficial owners' investments, presume to override the intermediary trustees and the investors' own prejudices and impose policies that they know to be more prudent for someone investing for retirement?

The outside directors of Boeing were the 401(k) owners' last defense in protecting the retirement savings. They were chosen according to a formal technical definition of 'independence'.

There was no consideration of seeking people with a psychological profile for integrity, commonsense, and the strength of character needed to stand alone and protect distant, hypothetical shareholders, willing to endure social discomfort and ostracism and face down the Chairman and his supporters.

Those who succeed in corporate and government bureaucracies, do so by getting along and by being willing to accept group norms. Even without ulterior motives or secret scheming, it is highly unlikely that professional executives who make it to the top of public companies would nominate anyone to the board who was not of like mind regarding executive remuneration.

Birds of a feather flock together.

Warren Buffett, in the Berkshire Hathaway 2002 report to shareholders, explains why independent directors fail to protect shareholders:

Why have intelligent and decent directors failed so miserably? The answer lies not in inadequate laws – it's always been clear that directors are obligated to represent the interests of shareholders – but rather in what I'd call 'boardroom atmosphere.' I

t's almost impossible, for example, in a boardroom populated by well-mannered people, to raise the question of whether the CEO should be replaced.

It's equally awkward to question a proposed acquisition that has been endorsed by the CEO, particularly when his inside staff and outside advisors are present and unanimously support his decision. (They wouldn't be in the room if they didn't.)

Finally when the compensation committee – armed as always with support from a high-paid consultant – reports on a mega grant of options to the CEO, it would be like belching at the dinner table for a director to suggest that the committee reconsider.

Too Busy to Mind the Business?

One might also wonder whether the people who are actually selected as independent directors are qualified to safeguard the life savings of millions of anonymous small shareholders.

A study published by the University of Michigan (3) lists Boeing director Rozanne L. Ridgway among its cases of 'extreme multiple directors' and asks, in effect, whether she might be “too busy to mind the business?”

Since Ms. Ridgway was on the board of seven public companies (and a member of the Compensation Committee of Boeing) as well as co-chairperson of the Atlantic Council of the United States, a trustee of the National Geographic Society, the Center of Naval Analysis, the New Perspective Fund, the Brookings Institute, the George C. Marshall Foundation, the Appeal of Conscience Foundation, and Hamline University, the question is relevant.

Considering that Boeing directors meet monthly, it would appear that Ms. Ridgway would be obliged to attend some board meeting at least weekly, and possibly twice weekly.

She also was a member of the American Academy of Diplomacy, the Council of Foreign Relations, the Institute for the Study of Diplomacy at Georgetown University, the International Advisory Board of the Institute of International Studies at Stanford University, the Trilateral Commission, the Advisory Board of Women in International Security, and many other organizations with interests in U.S., foreign, and national security policy.

She found time to attend Bilderberg meetings and to lecture at various symposium and special venues, including the Orinoco River voyage of Ted Pedas' Astronomy Theme Cruises.

Ms. Ridgway might be fairly characterized as a Famous Person of Impeccable Reputation with Outstanding Credentials. She had been inducted in the National Women's Hall of Fame and had received the Presidential Citizens Achievement Medal, the Presidential Distinguished Performance Award (twice), the Secretary of State's Distinguished Service Award and Distinguished Honor Award, the Joseph C. Wilson Award for Achievement in International Relations, decorations from the governments of Germany and Finland, and seven honorary degrees.

Ambassador Ridgway was a Famous Person of Impeccable Reputation with Outstanding Credentials.

She had served as U.S. Ambassador to German Democratic Republic, Finland, and Ocean and Fisheries Affairs. Ambassador Ridgway had been the lead negotiator at all five of the Reagan/Gorbachev summits that led to the end of the Cold War. She had been a U.S. Foreign Service Officer for thirty-two years.

Considering the international scope of Boeing's business and the hard-ball negotiations that were necessary to assure access to foreign markets, Ambassador Ridgway's experience and top-level connections were clearly of immense value to the Boeing Company.

On the board since 1992, her skills and government connections were available throughout the difficult McDonnell Douglas merger which, although approved by the U.S. Federal Trade Commission, was opposed by the European Commission, requiring a vote of the U.S. House of Representatives to warn the European bureaucrats against blocking the deal, along with heavy, diplomatic arm-twisting behind the scenes.

In view of their outstanding connections in areas of government, the military, and business vital to Boeing, it would be fair to say that some of the non-executive board members were 'working directors' and that their worth to the company was probably much greater than their monetary compensation.

Certainly any investor would consider their stock to be more valuable for having such highly-qualified, well-connected people working in the interests of the company. In this lies the dilemma of corporate governance.

As independent directors become more involved in projects that further the interests of the firm, they become closely tied to management, attached to the CEO, and less independent.

In any case, there is no indication that Boeing management had reason to doubt that their independent directors would not recommend performance-based, competitive pay packets.

Certainly Ambassador Ridgway's views on executive compensation were known to be acceptable to executives of other public companies.

Besides serving on Boeing's compensation committee, she sat on similar committees at 3M Corporation and Manpower Inc.

Although she had no background in accounting or financial analysis, she was a member of committees that selected auditors for two other public companies: Emerson Electric and Sara Lee.

The 'Ideal' Independent Director

Professional managers , trying to find an independent director who would have sympathy for stock buybacks and options, might logically favor someone with useful connections and an outstanding reputation for public service, but known to be inclined to their views. Preferably, such a person would be so busy as to have no time to look deeply in corporate affairs.

The ideal candidate might be someone without experience in the private sector or deep knowledge of capital markets, who would be likely to follow management's recommendations on financial matters.

Such a candidate might have a long career in the public sector, far from the plight of those working for a wage, never having been subject to dismissal in economic downturns, and never having had to worry about retirement, while accustomed to discussing grand expenditures on a national scale.

From the point of view of the small investor anxious to save his retirement fund, it would be preferable to be represented by a director with the investment acumen, integrity, and investor-bias of, say, Warren Buffett.

However, the University of Michigan study, mentioned above, showed that their sample of 3,160 public corporations in the U.S. had a total of 23,673 directors.

If two-thirds of these were to be 'independent' and dedicated to a single company, as the proponents of corporate governance suggest, this would require fifteen thousand independent directors.

Unless a way could be found to clone Warren Buffett and the sage were willing to undergo such a procedure, it seems unlikely that their will ever be enough famous people with the necessary financial talents and fiduciary probity to fairly represent the interests of millions of small investors under democratic capitalism.

The Absentee Investor and Buybacks

The hermetic separation of beneficial owners from management, combined with the average investors' almost total ignorance about the companies they owned and their confusion about short-term value and long-term worth of retirement funds, are central to understanding the American capital market during the Great Bubble.

Many observers recognized that there was a problem, but Wall Street, the fund industry, and management had common interests that conspired against meaningful reform in corporate governance.

It is easy to think up measures that would solve the stock option/buyback problem, thereby improving the lot of small investors.

For example, the SEC could change accounting rules for public companies, requiring stock repurchases that were not proportionate to stock ownership to be treated as an expense, while greatly increasing disclosure of the impact of repurchases on long-term investors.

However, considering the political difficulty in exempting dividends from taxation, even with the strong support of President Bush, and the brouhaha over expensing stock options – small potatoes compared to stock buybacks – the political will to enact reforms that truly protect retirement savings of small investors, may take a long time to emerge.

As capital flow analysts trying to grasp the big picture, it should be irrelevant to us whether directors and executives of Boeing were complicit, misinformed, or even correct in their endorsement of spending nine billion dollars to repurchase company stock.

When thinking at the level of societal structures, it is unnecessary to interject moral judgments regarding individual motivation. The point should be that Boeing's actions were similar to those of other blue chip companies; stock repurchases reduced the supply of equities relative to demand and forced stock prices upwards, creating a Great Bubble.

In the end, when the ultimate shareholders are far removed, ignorant, and indifferent to the actions of directors and corporate executives, these executives will act in their own interests, not the interests of those who are virtual strangers.

The problem is in linking executive remuneration to stock prices.

The problem is not executive greed – most of us want more than we deserve – but rather the linking of management remuneration to stock prices by those who consider themselves champions of good corporate governance and guardians of anonymous investors – the managers of institutional funds.

Beneficial owners with long-term goals might be better served if performance were measured in terms of dividend yields, dividend growth and coverage, and corporate financial strength.

However, this kind of thinking was not common in Wall Street culture at the turn of the century. These were times of asset-lite perceptions.

July 25, 2020

Essay: end

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Notes:

(1) 'Empire', Niall Ferguson, Basic Books, New York 2003.

(2) '401(k) Plan Participants Characteristics Contributions and Account Activity', Investment Company Institute, Spring 2000.

(3) 'Too Busy to Mind the Business? Monitoring by Directors with Multiple Board Appointments' ,Stephen P. Ferris, Murali Jagannathan, A.C. Pritchard, University of Michigan, John M. Olin Center for Law & Economics, Paper 99-013, January 2002, web site

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